Originally published at 7IM.co.uk. 7IM is an investment manager partner of Wren Sterling. In this article they explain why enthusiasm for cryptocurrencies is inherently psychological and why 7IM has not bought in so far.
In the first quarter of 2021, the price of Bitcoin rose from $29,250 to $58,960 – up just over 100%. Anyone who bought it on the first day of the year doubled their money in three months. And we started to get a LOT of questions from our investors.
Most of the queries were sensible, from people worried that they’d wake up to find their 7IM portfolio stuffed full of crypto-currencies that they didn’t understand. We were able to reassure them that our investment process won’t be including anything which we struggle to value, don’t have long-term data for, and which we don’t understand from a fundamental point of view.
Why, oh why didn’t you buy?
But this article isn’t about those questions. It’s about the ones we had which were asking why we didn’t hold crypto-currency in our portfolios. Why were we missing out? Why were we behind the times? Why weren’t we taking it seriously? Couldn’t we see how good the returns were?
This article is about how those questions have vanished since Bitcoin fell 40% in the space of two weeks.
Those kinds of questions (and the absence of them) tell us a whole lot about the psychology of the marginal crypto-currency investor. Which can in turn tell us a lot about a market still in its infancy – and how long it might take to grow up.
Misbehaviour in humans
Humans aren’t computers. We’ve talked before about this, using the analogy of the “lizard”. Lots of the actions we take are driven by emotion as much as rational analysis. We all know what’s healthiest to eat but wave a Big Mac or a chocolate cake at someone and watch the rational human vanish as the hungry lizard takes over!
Lots of these “irrational” behaviours are found in everyone (1); we might do the wrong thing, but almost everyone else does too. This means there are common ways of behaving – or misbehaving – that we can study. The three biases which are worth mentioning here are herding, loss aversion and salience.
Herding is the tendency to follow other people’s behaviour when making decisions, rather than using your own judgement. Think about stepping out into the road at a crossing just because other people have, rather than waiting for the green light.
Loss aversion is simply that we feel the pain of a loss far more than an equivalent gain. Imagine buying a drink, and then knocking it over. Most of the time you’ll be far more annoyed about the spill than you were excited about getting it in the first place.
Salience is our tendency to focus on the more emotionally striking things in life, rather than less remarkable things. It’s the reason that newspapers have headlines, and that every online article has some sort of attention-grabbing spin to try and get you to click.
Misbehaviour in markets
The global equity market is worth around $90 trillion and has been around for well over two hundred years. The global bond market is over $120 trillion and has been with us for nearly five hundred years. About $5 trillion of foreign currency exchanges take place every day, and currency has been around for a couple of millennia.
Most of the time, human biases have little impact on these markets. Partly this is because there are hundreds of millions of people involved, and these biases can cancel each other out. Partly this is because there are long-established institutions with teams, processes and models which are designed to moderate the emotional impact of a single investor. And partly its because there are always smart people looking for an edge – often professionals whose entire way of making money is based on profiting from the emotional mistakes of others.
This means that any anomalies tend not to hang around for long. However, despite all these features, from time-to-time even the biggest markets are prone to bouts of greed and fear.
Now imagine the crypto-currency world, where things are a lot smaller and a lot newer. While Bitcoin has made headlines this year for being worth over $1 trillion, that’s happened very quickly. Back in October 2020 it was worth $200 billion. And it isn’t even a teenager yet, having started in 2009.
And its dominated largely by individuals, and their biases. Lots of research papers have been published about exactly this (2, 3) but the evidence is also all around us.
We saw herding as the price started to rise this year, with investors asking us why we weren’t investing. And it’s also been evident in the number of people who have been drawn in, buying different crypto-currencies not because they have clearly defined ideas about decentralised digital currencies, or care proof-of-work vs. proof-of-stake, but because everyone else has been buying them too.
We’ve also seen loss aversion as prices fell; people bailing out of something they bought the day before just because it has fallen in price. And once something starts the stampede for the exit, herding kicks in here as well.
Salience has perhaps been more important than ever. It’s not just adverts on the side of bus stops, or all over the internet. It’s been more obvious than that, even. Simply putting a timeline of Elon Musk’s tweets alongside the price of Bitcoin tells the story of salience; a popular, larger-than-life figure acting as an attention magnet, drawing people into the crypto-currency world.
We think that the technology behind crypto-currency could be extremely important. Decentralised ledgers and automatically executing smart contracts have very clear uses and might well be an important part of the next twenty years of technological development.
But. The market for this technology isn’t anywhere near developed yet.
And while we completely understand that there will always be behavioural anomalies in investing – indeed, that’s what makes our jobs possible – we also need there to be a rational mechanism which corrects those anomalies over time. That’s simply not the case in the crypto-markets, as the events of the last five months has shown us.
1 Whether or not these behaviours are irrational is a fierce source of debate – if no-one follows a rule, is it really a sensible rule to have? This Dan Ariely book is a really approachable read on the topic https://danariely.com/books/predictably-irrational/
2 Al-Mansour, 2020, Cryptocurrency Market: Behavioral Finance Perspective, Journal of Asian Finance https://www.researchgate.net/publication/346565632_Cryptocurrency_Market_Behavioral_Finance_Perspective
3 Gurdgiev & O’Loughlin, 2020, Herding and Anchoring in Cryptocurrency Markets: Investor Reaction to Fear and Uncertainty, Journal of Behavioral and Experimental Finance https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3517006